yield-curve targeting

Scott Sumner's big idea is that the Federal Reserve should target expected values of nominal GNP. When he's been his most concrete, he suggests an automatic program to inject certain amounts of money through open market operations when futures on GNP drop below a certain level, and withdraw this liquidity when futures exceed the level. I've been thinking about this and related things for a while, and want to put forth an idea related to them.

First I want to discuss level targeting versus growth (which, in the case of prices, is called "inflation") targeting. I tend more toward the former camp because the time-consistency problems are less bad there; if, in response to 1% inflation in response to a stated 2% target, you continue to assert a 2% target, the market will continue to expect what it continues to expect; you can get self-fulfilling expectations. With a price level targeting system, targeting price levels along a path with 2% annual growth, if inflation comes in at 1% one year, you aim to make it up; markets can form better grounded expectations that, a few years from now, price levels will be around what you've promised, and to the extent that expectations are self-fulfilling will even help you get there rather than wandering off in persistent indifference to your stated policy.

Level targeting per se suffers from a different sort of time-consistency problem, though, or perhaps two different, though closely related, such problems. If prices move too far off the target path, the Fed may be under pressure to revise the target; the choice is then between insisting on remaining firm, possibly requiring deflation or high levels of inflation, or revising the target, in which case a lot of credibility goes out the window. (This working paper from 8 years ago titled "Tough Policies, Incredible Policies?" notes that imposing costs on oneself to generate credibility means one might incur those costs in an extreme event, making the situation worse; this is related.) On a related note, on adopting the regime, a target level has to be decided upon and announced; particularly early on, there will be speculation as to whether the Fed would, at some point, use whatever criteria it used to set the initial target path to set a revised target path.

What I support therefore lies somewhere between a level target and a growth target: revise the target level by some fraction of the deviation from the target path. If this fraction is 1, you have growth targeting; if it's 0, you have level targeting. If you use between 0.03 and 0.05 per quarter — a decay time of 5–8 years — your target is pretty rigid over the course of a year or two of ordinary noise, such that it invites self-fulfilling forces in its favor, but large deviations are partially accommodated, making it more credible that the Fed will continue to maintain the policy in the face of a crisis — abandoning (slightly) its target, but in a pre-determined way, such that markets can form expectations, and those should generally (again) be stabilizing. Further, this policy could be adopted today and would spit out the same target level as if it had been in use for 25 years; not only does this mean that "revising" the target, according to the same criteria, several years down the road would mean no revision, but it means that the Fed builds credibility for the regime more quickly, as it has no less reason to revise its target soon after adoption than it would in midstream, and can demonstrate that the target level wasn't simply chosen to be easier, for political reasons, to hit.

I like the idea of targeting nominal GNP better than targeting prices, partly because it feels like a change in real GDP should be met by an accommodating change in the level of inflation targeted — that is to say, the direction at least is right, that it makes sense to lower the inflation target when the economy is growing quickly and to run monetary policy that is looser than a strict inflation target would give when the economy is weak. I also like it because I think it can be measured better; price targeting requires deciding which prices to target, and measuring those prices requires hedonic adjustments and the like, while nominal GNP, at least in principle, is simple: just add up dollars for everything, regardless of how the goods or services for which they're exchanged have changed from the previous period. (I don't care as much between GNP and GDP, and seem to have gotten sloppy about which I use. They're close — at least as close as are the fed funds rate and the T-bill rate, which I'll implicitly conflate shortly — and I expect Scott has better reasons for supporting the one he supports than I would have for either.)

Over the short run, I would rather maintain the practice of targeting short-term interest rates rather than the quantity of money (any money); the difference between the two policies amounts to a difference in accommodation of short-term variations in liquidity demand as, for example, pay checks clear. It seems likely to me that putting this variation in the quantity, rather than price, of liquidity will impose less volatility on the real economy. I will, at the moment, simply ignore any problem this creates when interest rates are 0. This is part of the privilege of having a blog.

What I'm looking at, then, is a regime of calculating how far GNP is from a target that largely grows at a constant rate, but will absorb deviations over the course of a business cycle, and targeting an interest rate based on the deviation from the trend and expectations of growth in the near future. If growth has been too low lately, we lower interest rates; similarly, if it's expected to be too low in the near future, we lower interest rates.

What interests me — what triggered this post — is that, once you're in a credible policy regime of setting short-term rates based on recent deviations from your targeted long-term growth rate, you don't need to create a market for GNP futures; long-term interest rates are expected future short-run interest rates, which will depend on expected GNP growth. At this point I simply make short-term interest rates a function of the current deviation of GNP from its target and of, say, ten-year treasuries.

I'm not sure yet what relationship is required between the parameters to ensure determinacy, or to make this most nearly result in actually targeting expected GNP (at some given distance in the future), but I had an idea a few years ago — before I started taking macroeconomics classes — that perhaps the FOMC should direct the open market desk to target a certain steepness for the yield curve, just on the grounds that, hey, if long-term interest rates move down, we probably want short-run rates lower, too. I don't know that "1" is the right coefficient to put on any duration of interest rate (or a weighted average of such interest rates); perhaps it would not be. In any case, I have some aspirations at some point to try to write this down and solve for interest rates in terms of parameters and GNP expectations, but that should probably wait until the summer.